Critique of Fed President Charlie Evans' Speech

A couple of days ago Chicago Fed President, Charlie Evans, gave a speech at
the Bank of Ann Arbor detailing risks he perceived to the U.S. and global
economies, along with a number of opinions on what actions governments and
central banks could take to curtail those risks. When juxtaposed with Austrian
economic theory, the speech by Mr. Evans was so riddled with fallacies, I
could not help myself but document the offences. Excerpts from Mr.
Evans' speech are italicized below, followed by my responses.

I have vigorously supported strongly accommodative monetary policy measures
as the appropriate response to the unacceptable state of the U.S. labor
market.

Monetary policy does not create productive labor, but rather the opposite.
History does show that accommodative policy stimulates activity, but this
activity usually circumvents natural market forces which direct resources
to their most productive uses. The ultimate result is an exacerbation of economic
woes when the next cyclical downturn arrives.

A recent example can be found in the Fed's response to the bursting of the
tech bubble. Artificially low interest rates in combination with well-intentioned,
but faulty government policy, lead to a speculative bubble in housing. I do
not believe any economist can credibly deny that resources... both labor and
natural... were wasted building millions of homes for which no one had an
immediate, practical use. This misallocation of resources eventually manifested
in enormous economic loss as revealed by the 2008 financial crisis.

The context for our recent actions is an economy that has been growing,
but not at a pace fast enough to restore it to its productive potential
in anything close to a reasonable amount of time.

We all may have opinions about what is a reasonable recovery time, but no
one person or group is smart enough to know this answer. Such statements are
simply excuses for central planning, and once again, history is has not been
kind to centrally-planned economies.

More monetary accommodation and greater confidence in the future mean a
stronger U.S. economy.

Monetary accommodation distorts the price discovery mechanism for the most
important price in any economy: the price of money. Without a free market
for interest rates, business operators cannot make judgments that use resources
most effectively because more ventures appear viable, thereby putting a greater
strain on available labor and raw materials. By allowing the market to set
a higher price for money, only those operators who could run a business profitably
with higher cost... in other words, those who know how to use resources most
efficiently... would have access to those resources. The prevailing interest
rate used to be called a "hurdle rate" for a reason: the price of money would
reveal whether or not a venture was economically viable. In the absence of
an appropriate hurdle rate, many more ventures appear viable than would otherwise
be. While this outcome appears to be the objective of accommodative policy,
the result is a waste of resources and lower long-term wealth for the nation.

In the absence of further monetary stimulus or fiscal repair, the outlook
would be for more of the same: moderate growth that is not strong enough
to generate substantial improvement in the labor market.

In the absence of further monetary stimulus, the economy would undoubtedly
suffer a sharp downturn. However, the process would be reparative. Inefficient
businesses would fail. Bad debts would clear. Deflation would also set in,
bringing down labor costs in conjunction with the prices of resources and
consumer goods. Those with heavier debt loads would suffer the burden of repaying
debts with a stronger currency than they borrowed. These effects would be
fleeting, however, as the process of pushing resources toward more productive
use produces greater national wealth in the long run.

A great deal of state-of-the-art analysis -- done both inside and outside
of the Fed -- indicates that the severe downturn in 2008-09 was mainly
the result of a large drop in aggregate demand which left the economy operating
below its potential.

The drop in aggregate demand seen during the 2008-09 financial crisis was
a side effect, not a cause, of the downturn. Excessively high debt levels
and mispriced assets... both the result of accommodative policy... were the
cause of the crisis. In fact, every major financial crisis in history can
find its roots in the abuse of an effectively fiat currency. Even U.S. crises
of the 19th century... when we were purportedly on a gold standard... came
in the aftermath of speculative bubbles fuelled by banks which issued paper
in excess of specie they held in reserve.

Research also shows that better and more accommodative policies have the
power to reverse these setbacks and raise employment, output and incomes.

Such research only considers benefits in nominal terms, but when a currency
is constantly devalued by accommodative policies, the benefits in real terms
turn into losses. Furthermore, the effects of accommodative policy, even nominally,
lessens in proportion to outstanding debt within a society, and increased
debt is a side effect of such policies, explaining why each crisis requires
a larger stimulus. Furthermore, debt is the most insidious threat to the potential
for economic recovery, meaning that in the long run, accommodative policy
is a very destructive force.

Furthermore, appropriate policy can deliver these better outcomes without
generating inflation that is significantly higher than the Fed's long-run
goal of 2 percent.

The fudging of inflation numbers is an open secret. No one who buys gas or
groceries believes that inflation is truly running near 2%. Independent economists
such as John Williams calculate inflation closer to 6%, and this elevated
inflation rate is occurring during recession. More rapid price increases have
not yet materialized due to rather tame money velocity. Ironically, if the
Fed achieves its goal of spurring nominal economic activity, the reins of
inflation will be lost.

There are many who believe otherwise. In their view, our current low output
and high unemployment are the hallmarks of an economy that has lost its
competitiveness.

Not at all. Our current economic stagnation comes from a combination of inefficient
resource use... a problem that the marketplace could solve in the absence
of central planning... and an uncertain political landscape. The threat of
a further consolidation of central control and confusing signals from national
leaders regarding attitudes toward business, among other issues, have paralyzed
innovation and productive risk-taking.

Carmen Reinhart and Kenneth Rogoff and others find that, given the monetary
and fiscal policies that are typically pursued, a prolonged period of slow
growth following a financial crisis is the unfortunate norm.

Mr. Reinhart and Mr. Rogoff need to study conditions rather than make generalizations. The
panic of 1819, which like the current crisis followed a period of national
speculation in real estate, saw economic expansion return in less than
18 months because the market was left to clear itself. Prolonged periods
of slow growth, most notably during the Great
Depression, did not become the norm until politicians decided they
knew better than the market how to fix the economy.

Whenever the economy operates below its potential, the key mechanism that
returns the economy back to potential is a fall in real interest rates.

A fall in real rates does lower the hurdle rate which thereby plays a role
in creating economic activity. However, a more powerful stimulative effect
comes from lower resource prices as demand falters. Unfortunately, accommodative
policy is designed to fight deflation, thereby negating one of the key mechanisms
for clearing malinvestment and transferring resources to those who can use
them more productively.

Over the past couple of decades, world economic growth has depended heavily
on U.S. consumers. Our consumer spending was a critical driver of growth
in auto sales, electronics, housing and technology -- all of which not
only benefited the U.S. economy, but also supported growth beyond our borders.
Given the forces holding back U.S. consumers, the world economy can no
longer count on U.S. households to drive growth. Other countries need to
take steps to stimulate their own domestic demand.

This obsession with consumption by mainstream economists is terribly misguided
as the focus is once again directed toward a side effect, not a cause. Consumption
is the privilege granted as a result of production. Production creates wealth.
Consumption consumes it. Why should policy be directed toward the consumption
of wealth? If government must interfere in some way in the economy, our politicians
should at least be advised to find ways to stimulate innovation and investment.
However, the best long-term policy is to minimize the size of government so
as to leave resources available to private enterprise where natural human
spirit and innovation will put assets to their highest and best use.

For a country with its own currency, a quick channel for achieving improved
competitiveness is currency depreciation.

Competitiveness gained through currency devaluation is superficial because
you are not operating more efficiently but rather simply exchanging your assets
for less of a foreign currency. (A wiser move would be to strengthen a foreign
currency after you have acquired it.) Furthermore, advocates of a weaker domestic
currency neglect the other side of the equation: purchasing resources from
overseas becomes much more costly. So not only does a weak currency allow
a country to trade their goods for less of a foreign currency, the
country also has the privilege of spending more of their own currency
for imported goods. This trade-off hardly seems like a path to prosperity.

In addition, under current law, in the absence of a budget deal, there
will be automatic sequestration of spending amounting to $1 trillion over
a 10-year period... And unfortunately, a political stalemate that triggers
slated spending cuts -- an extreme outcome -- cannot be ruled out.

Cutting $1 trillion over 10 years... only $100 billion per year... is hardly
an extreme outcome with the deficit running at over $1 trillion annually and
total spending of $3.6 trillion. We need much larger spending cuts before
the U.S. debt becomes too large to manage without a massive monetization,
a process that would be far more mendacious to prosperity than a temporary
depression.

Specifically, I believe we should adopt an explicit state-contingent policy
rule that commits the Fed to providing accommodation at least as long as
the unemployment rate remains above 7 percent and the outlook for inflation
over the medium term is under 3 percent... Note the importance of the inflation
trigger -- it is a safeguard against unacceptable outcomes with regard
to price stability.

Unfortunately, many other central bankers who have advocated counterfeiting
operations... the expansion of the Fed's balance sheet creates money out of
thin air... have had the audacity to believe they can tap the brakes on inflation
at just the right time, but none of them have succeeded. Once money velocity
picks up, inflation will accelerate too quickly to be controlled. Accelerated
economic activity also brings higher interest rates. Since higher rates imply
lower bond prices, the Fed cannot possibly withdraw the money that was injected
through bond purchases since the sale of those bonds will bring less money.

Furthermore, any rate of inflation is corrosive to wealth. Even if the stated
3% rate were accomplished, our currency would lose 25% of its purchasing power
in a decade. If the inflation rate runs closer to the 6% calculated by independent
economists, our currency will lose half of its purchasing power in a decade.
Savers, and especially retirees, are therefore forced to either spend or speculate
with what they thought was a store of wealth. Such inducements hardly seem
prudent.

And stating that we expect to keep a highly accommodative stance for policy
for a considerable time after the recovery strengthens is an important
reassurance to households and businesses that Fed policy will not tighten
prematurely.

Maintaining accommodative policy after the velocity of money picks up guarantees
a higher rate of inflation. Mr. Evans' policies are obviously contradictory.
We were quite fortunate as a nation that after Alan Greenspan set the precedent
for such nonsensical policies in the late 1980s, the Soviet Union fell. The
fall of the iron curtain resulted in flood of natural resources, helping tame
inflationary pressures. We have no such crutch at this juncture... just the
opposite. With burgeoning demand from China and India, resources prices are
already under pressure to rise. Devaluation of our currency will only make
the effects more dramatic.

If we continue to take only modest, cautious, safe policy actions, we risk
suffering a lost decade similar to that which Japan experienced in the
1990s.

Japan has lost two decades, not one, and the culprit is excessive intervention.
Cultural issues compelled the Japanese to preserve revered institutions rather
than let them fail, thereby preventing resources from finding more efficient
use. The result of Japan's "cautious" escapades is an debt to GDP ratio over
200% and interest payments in excess of 20% of government revenue... both
dwarfing any other industrialized nation, including Greece. So rather than
preserve their nation's wealth, Japanese policy has instead spent it, with
little to show in return. Mr. Evans now proposes the U.S. adopt a similar
policy, but an order of magnitude larger in order to avoid the "error" of
caution. The policies he advocates are reckless, and history shows them to
be destructive to wealth and prosperity.

Our leaders must stop confusing symptoms with causes. We must return the power
of setting the price of money to the marketplace. Uncertainty over business
policies must be removed in order to raise the confidence of entrepreneurs.
And most importantly, Congress must quickly adopt policies to control national
debt, and protect the basic quality of money as a store of wealth.

Deric O. Cadora is the editor of The DOCument, a daily newsletter offering
equity and commodity market cycles analysis, macroeconomic discussion, and
general market commentary. Deric is a professional trader and a General Partner
of The Rutledge Group, a managing partner of a commodity-centric investment
partnership. His investment and trading experience spans two decades, during
which time he formed and served as principal of a broker-dealer, managed a
long/short book on the proprietary trading desk of Citi Capital Markets, worked
as an independent trader, and currently serves as Chief Portfolio Manager for
a commodity-centric investment partnership.